On May 28, 2015, in an apparent matter of first impression, the US District Court for the Central District of California affirmed the Bankruptcy Court in A62 Equities LLC v. Chohan (In re Chohan), holding that the assignee of an early termination payment under a swap agreement was not a "swap participant" for purposes of sections 362 and 560 of the Bankruptcy Code. The assignee was therefore not entitled to safe harbor exemption under section 560 of the Bankruptcy Code from the automatic stay and could not immediately collect the early termination swap payment from the debtors that had been assigned to it (532 B.R. 130 (C.D. Cal. 2015)).

On April 11, 2006, Shaukat and Mahmooda Chohan and US Bank, National Association entered into an interest rate swap agreement composed of an ISDA Master Agreement (ISDA Master), a cross-collateralization agreement and other documentation. Under these documents:

In 2006, shortly after entering into these agreements, the Chohans obtained a loan from the bank, secured by a trust deed, a security agreement and an assignment of rents. Two years later, in 2008, the Chohans took out a second loan from the bank secured by similar collateral and documentation. Per the cross-collateralization agreement, these assets also provided security for the Chohans' obligations under the swap agreement.

On June 8, 2012, the bank notified the Chohans that they were in default under the interest rate swap, that the early termination date would be June 12, 2012 and that the early termination amount was $527,384.59. The bank added this early termination amount to the amounts outstanding under the Chohans' loans, but it failed to exercise its immediate right to payment of the early termination amount it was entitled to under the ISDA Master.

A62 Equities (A62) asserts that on January 25, 2013, the bank sold to it the 2006 and 2008 trust deeds, the security agreements and assignments of rents, and its interest in the ISDA Master and the other Chohan documents. The Chohans did not consent to these transfers.

On June 6, 2014, the Chohans (debtors) filed for Chapter 11 bankruptcy protection.

On July 3, 2014, the debtors moved to establish the scope of the automatic stay in connection with A62's assignment and pending foreclosure sale on the trust deed, which was pledged as collateral for the debtors' obligations on swap agreement under the cross-collateralization agreement, to recover amounts owed under the terminated swap agreement and outstanding balance under the loans. The Bankruptcy Court heard the motion on July 8, 2014 (prior to a scheduled foreclosure sale of the trust deeds on July 14, 2014), and ruled that:

The US District Court for the Central District of California (Court) affirmed the Bankruptcy Court's rulings, finding that the post-early-termination assignment did not make the assignee a "swap participant" under section 362 of the Bankruptcy Code. Rather, the assignee was a secured creditor of the debtors, to which the automatic stay applied.

The Court acknowledged that the right to receive payment was derived from the swap agreement and the related security documents. The agreement was undeniably a swap agreement, as it was an agreement to exchange cash flows at specified intervals, calculated with reference to an index, as defined by the US Court of Appeals for the Ninth Circuit (see Thrifty Oil Co. v. Bank of Am. Nat. Trust & Sav. Ass'n, 322 F.3d 1039, 1042 (9th Cir.2003)). Even though the swap agreement was terminated, the amounts owed under the swap agreement remained outstanding, indicating that, absent an assignment, the original counterparty (the bank) would have been a swap participant entitled to be exempt from the automatic stay. Thus, the question facing the Court was whether the bank's assignment to A62 conferred swap participant status upon the assignee.

A62 argued that, as the bank's assignee, it stood in the bank's shoes and should be considered a swap participant for purposes of section 560 of the Bankruptcy Code. The Court acknowledged that, under basic contract principles, it is true that A62 would step into the bank's shoes. However, the Court noted, this reasoning did not necessarily address what rights the bank assigned or was entitled to assign.

To determine what interest was assigned, the Court examined the nature of the amounts outstanding under the agreements. The right to payment of the early termination amount (which survived termination) was for an amount that had already been calculated, become due and remained outstanding. Thus, the only assignable right was the right to collect the already specified termination amount, not the right to engage in the swap transaction, which had been terminated. Moreover, under the anti-assignment provision of the ISDA Master Agreement, without the Chohans' consent, the swap agreement itself could not be assigned, and the only validly assignable interest was the bank's interest in the termination damages. The Court found this insufficient to render A62 a "swap participant."

The Court supported its view using a two-pronged analysis.

First, since the Code sections were unambiguous on their face, the Court utilized the Oxford English Dictionary to define participant as "one who participates in something . . . a partaker. . . . " The Court determined that A62 did not participate in the swap because it did not exchange periodic payments with the debtors. Therefore it was not a swap participant that was entitled to avoid the automatic stay.

Second, even if the statute were determined to be ambiguous, the Court found that the legislative history indicated that allowing swap participants to avoid the automatic stay was intended to reduce volatility in the financial markets. Specifically, the provision is intended to permit immediate termination of swap transactions to address two risks prejudicial to the non-bankrupt/non-defaulting party:

Sections 362(b)(17) and 560 of the Bankruptcy Code address these concerns by allowing the non-bankrupt swap counterparty to accelerate the swap agreement, to collect outstanding amounts thereunder and to terminate the relationship (which would otherwise be a prohibited ipso facto provision under a non-safe harbored agreement).

However, these risks are not present in the post-early-termination transfer of damages that have already been concretely established, have become due and are not subject to swap market volatility or price movements. Once a swap agreement has been terminated, volatility risk no longer exists, and the only risk associated with the amount due is that the counterparty may fail to make the early termination payment. In the case of an early termination, the counterparty has already defaulted, and the prospect of recovery as a secured creditor is easily identifiable and on par with the risk facing any other secured creditor.

The Court noted that if it allowed the assignee to avail itself of the safe harbor protections of section 560, it would insulate the assignee from normal credit risk associated with recovering a secured claim in bankruptcy instead of swap market volatility, which Congress did not intend to do. Relying on the US Court of Appeals for the Second Circuit's ruling in Swedbank (445 B.R. at 137), the Court noted further that extending the scope of section 560 to confer "swap participant" status to the purchasers of termination amounts, thereby exempting assignees from the automatic stay, could cause substantial arbitrage risk, permitting parties to seek out terminated swaps agreements (which are not subject to volatility risk) and purchase them to obtain superpriority status that would extend to all of the assignee's commercial dealings with the debtor. (While it was not clear from the case, it appeared that A62 was attempting to piggyback claims under the trust deed and other documents on what it viewed was its right to a safe harbor from the automatic stay under section 560 for swap agreements.)

Lastly, the Court acknowledged that its ruling would create discrepancies in the rights between assignor and assignee. However, given the importance of the automatic stay and the intended effect of the swaps exemption from the automatic stay, the Court should construe the exemption narrowly to exclude assignees of liquidated swaps contracts.

Under the Bankruptcy Code, there is little question that the bank could have immediately foreclosed upon the property of the debtors on the early termination date, June 12, 2012, or at any time thereafter, irrespective of the automatic stay, in order to liquidate the trust deed which secured the early termination payment obligations under the swap.

However, by selling its rights to the damages under early termination instead of exercising them and collecting the outstanding amount as a swap participant, the right to avoid the automatic stay under section 560 of the Bankruptcy Code for this debt was forfeited. However, it is notable that the Court ignored a major risk associated with the settlement of swap agreements. One of the primary justifications for special treatment of swap contracts in bankruptcy is to avoid systemic instability.

While the Court acknowledged that the volatility risk facing the swap counterparty is an important consideration in determining how to apply the Bankruptcy Code, it ignored the larger effect that non-payment of swap early termination payments could have on the larger financial system. The early termination feature allows financial institutions to retain liquidity in the face of counterparty defaults. Disallowing the early termination and actual payment of these contracts could significantly reduce liquidity in certain circumstances, which, according to some, could lead to systemic instability.

If the payment had been large and the assignee had been a major financial institution, the very purpose of the automatic stay could have been frustrated by this ruling.

In this circumstance, with the relatively small notional value of the swap entered into by what appears to be homeowner hedging interest rate risk for a variable rate mortgage, such systemic risk is hard to imagine. But the old adage that bad facts lead to bad law could apply to the Court's analysis of the risks intended to be addressed by these Bankruptcy Code sections.

For more information on early termination, see Practice Note, The ISDA Master Agreement: Early Termination.

For more information on bankruptcy safe harbors, see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist.